It's been a puzzling summer for bond fund investors. The widely anticipated selloff in bonds somehow morphed into a rally, despite spiraling oil prices and a
chairman unwilling to see mixed economic data as anything more than a "soft patch" in the economy. Historically, under these conditions, rates should have spent the past three months rising, not falling.
The benchmark 10-year Treasury has traded around 4.25%, down from a June high of 4.88% and right back to where it was in April. But many strategists do not expect this low-rate reprieve to last and are steering clients out of Treasuries into tax-free municipal bonds before oil prices drop and the Fed hikes rates in September.
A municipal, or muni, bond is a debt security issued by a state, municipality or county in order to finance capital expenditures, such as bridges or sports stadiums. Municipals, as opposed to taxable bonds like Treasuries and corporates, are exempt from federal taxes and from most state and local taxes, especially if you live in the state the bond is issued, which is the essence of their attraction.
Munis' favorable tax implications make them a staple in the portfolios of baby boomers close to retirement and a must-have for people in high-income tax brackets, particularly those in states with high state and local taxes, such as New York. But analysts say a rising interest rate environment will increase the demand for munis, making them attractive to more than just the wealthiest investors.
Stagflation and the '70s
Analysts say the recent drop in rates will be fleeting because it runs counter to the traditional pattern. Just rewind your memory back to the 1970s and recall the stagflation -- low growth, high inflation -- caused by rising prices at the pump. And higher oil prices have historically led to higher interest rates.
"A lot of this summer's rally in bonds has to do with higher oil prices and speculation in the oil markets," says Dave Fare, co-portfolio manager of the $2.6 billion
Smith Barney Managed Municipals fund. "Even over the last few days you have seen rates tick up as oil prices have come off their highs."
In mentioning the link between higher oil prices and interest rates, Fare is referring to a widely-held hunch on Wall Street this summer that higher oil prices will act as a brake on economic growth and prevent the Fed from aggressively raising rates. But like most muni portfolio managers, Fare rejects this idea and expects the Fed to continue its series of rate hikes. He predicts the Fed's overnight lending rate to be at 2% by November, up from its current level of 1.50%.
"It's been a very surprising summer, but we expect rates to rise," says Bill Fitzgerald, managing director of
. "And when that happens, muni bonds tend to outperform taxables."
Analysts point to a favorable supply/demand dynamic as one of a number of reasons why munis are the bonds of choice in a rising rate environment. The primary reason for the positive supply/demand outlook is quite simple: a lack of foreign demand.
Unlike domestic buyers, non-U.S. investors are ineligible for the significant tax benefits. That means muni prices would hold up well in the event that investors outside America display less of an appetite for Treasuries, a scenario that has become more of a possibility as the U.S. government continues to run a massive budget deficit.
And while the government has increased the supply of Treasury bonds in order to fill the gaps, state and local governments have reduced their muni issuance so far this year, according to analysts. Mark McCray, portfolio manager for the $330 million
PIMCO Municipal Bond fund, says he expects gross new issuance to be $300 billion in 2004, down from $380 billion in 2003.
Most analysts say the state and local governments will not need to flood the market with muni bonds because they cleaned up their balance sheets during the downturn by refinancing older, higher coupon-rate debt.
Nuveen's Fitzgerald points to Standard & Poor's recent upgrade of California's bonds from a triple-B to single-A as an example of the enhanced quality of state debt.
"States have been fiscally responsible during the last several years," says Fitzgerald. "Some states raised taxes to supplement revenue and will be able to hold up well even if the economy grows at 2.5% to 3% instead of 3.5% to 4%."
Valuation is another oft-cited reason for the expected shift from Treasuries to munis. Thomas Metzold, portfolio manager for the $2 billion
Eaton Vance National Municipals fund, says, "Whether or not we are in a rising rate environment, munis are yielding 90%-95% of Treasuries. So if you are in the 26% to 30% tax bracket, you are always better off switching to munis."
Here's what he means by that. Last week, a 30-year triple-A rated (the highest muni rating available) municipal bond was yielding 4.88% compared with 5.05% for the 30-year Treasury. Dividing the muni yield into the Treasury yield gives you a whopping 96%. PIMCO's McCray says historically the percentage is closer to 85%. He expects the spread to decrease to 75% to 80% as muni prices strengthen and yields fall.
Now here are the tax advantages of that muni bond using the same example: If you are in the 30% tax bracket, the tax equivalent yield for this particular muni is 6.97%. (In order to calculate yield equivalence, divide the tax-exempt yield, in this case 4.88%, by one minus the investor's tax rate, 30%; or, in other words, divide 4.88% by 0.7.) On a tax-adjusted basis, then you would have to buy a 30-year Treasury yielding 6.97% -- remember that the current 30-year Treasury is yielding about 5% -- to match the tax-free returns on a similar muni bond yielding 4.88%.
Finally, bond strategists say an economic expansion means higher tax revenue to service both old and new municipal debt, as well as eliminating the need to increase supply by issuing additional debt.
Bush, Kerry and the Economic Risks Ahead
Not all muni analysts, however, are looking for rates to move up that quickly. A small but growing contingent says this summer of surprisingly low rates might not end so quickly if economic data showing a slowdown in the economy is right and Chairman Greenspan's vision of a summer "soft patch" is wrong.
"People were expecting a strong return to growth, but now the latest projections say that things are slowing down," says Dennis Farrell, group managing director for public finance at Moody's Investment Service, a bond rating firm. "Municipalities might not be in the strong financial position they thought they were at the beginning of the summer."
If the municipalities are not in as good a fiscal shape as they projected, that means they will have to go back to the market to raise funds -- increasing supply -- and most probably pay a higher coupon rate to attract wary investors.
Farrell also says actual revenue projected for municipal coffers might be less than projected due to oil and gas increases, a slowing in the equity markets, and concerns about terrorism increasing municipal expenditures. That's because unforeseen expenditures often lead to budget shortfalls, which require more borrowing.
"Expenses are going up in states that are defending large, attractive targets like ports and financial centers," says Farrell.
And some of those attractive targets are in states that might have cleaned up their balanced sheets over recent years, but are still not totally out of the woods. In June, for example, S&P lowered New Jersey's outstanding general obligation debt rating to double-A from double-A-plus because of the state's financial difficulties. And despite the recent upgrade in California's debt rating, most analysts say the Golden State is still in need of a good fiscal plan.
"While credits as a whole are better than they were a couple of years ago, there are still some spots that need improving," says Smith Barney's Fare. "We are hoping states put their fiscal houses in order during the downturn, but that's on a state-by-state basis."
Although Wall Street traditionally veers toward the right on financial issues, a final risk for the muni market may be a Republican victory in November. That's right. The supply and demand of munis is very much dependent on changes in the tax code, so most analysts say a Kerry victory -- and the higher taxes that would likely follow it -- would stir wealthy Americans to snap up muni supply, thus boosting prices.
"Kerry would be better for the muni market because he wants to raise the taxes of wealthier Americans. That would make munis more valuable as demand will increase," says Nuveen's Fitzgerald. "A Bush victory would hurt muni prices because it involves a flatter tax code and lower taxes."